Why Prime Brokers Could Be a Source of Crypto Contagion

Digital asset markets have been vibrant recently, and this has been a great respite after almost two years of crypto winter. I do not want to throw a wet towel on current sentiment, but it is good to remember that the seeds of the next crash are often sown during the good times.

Because risk management is the primary job of all portfolio managers, here I want to opine on one potential scenario if this bull market continues for another 18-plus months.

Here is why I think the potential nexus for future contagion could be prime brokers (PBs).

Why? Because 1) PBs are emerging as a major player and lender in crypto markets and2) The current lending standards of PBs are tight, largely lending to low drawdown strategies (like delta-neutral), and presents low systemic risk. But, 3), if expected returns of delta-neutral strategies decline, then PBs may move out the risk curve in terms of who they are willing to lend to and what services they offer, which could brew systemic risk.

During the last bullish cycle, lenders increased the violence of the implosions that we witnessed. Leverage was hidden across a network of entities (BlockFi, Voyager, etc.), with concentration at certain nodes (3AC, Alameda). The lenders of the old-world are largely gone, but there is a new source of liquidity: prime brokers (PBs).

Currently, PBs generate most of their revenues through 1) trading revenues from market access, and 2) lending revenues from lending, typically to delta-neutral strategies.

Funding arbitrage is a strategy which benefits from market demand to go long via derivatives. This exploits the funding interest rates paid out from perpetual swaps (a crypto derivative product) by going long on spot and short perpetual swaps (or vice versa). This generates attractive yields and exploits market demand to go levered long, while not exposing the strategy to directional market moves. If the strategy is implemented well, the risk is very low, which makes it a popular strategy for PBs to lend to.

While funding rates are currently elevated from recent upside price action, I believe it is reasonable to expect the returns to come down as more money flows into these lower-risk strategies. With returns declining in funding arbitrage, we will likely see returns in other lower risk strategies fall. If expected returns decline below the borrow cost from PB loans, then the PBs will be forced to make the decision to move out the risk spectrum or reconsider their product offerings.

What could this apocalyptic future fueled by crypto PB collapse look like? What could it be fueled by?

Here are a couple ideas:

Further aggregation of liquidity through PBs: Increasing volume requirements for better fee tiers at centralized exchanges, like Binance and OKX, will push most traders to access the market through PBs instead of their own master accounts.

Synthetics, swaps, other derivatives: If trading directly on exchange becomes restricted (either due to the exchanges themselves limiting direct access, or the PBs limiting access), this may create a market of derivatives for traders where the PB will clear the other side (usually this is a swap mechanism). This opens the door for accounting issues, or leverage shenanigans.

We should enjoy the good times while they are here, while also considering future disaster scenarios. Stay safe out there, everyone.

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